Structure of teacher pensions is ticking time bomb

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What could be worse news than public school teacher pensions across the country reporting an unfunded liability of more than $330 billion? How about the fact that these reports understate the size of the liability by a factor of three?

Recently, the Manhattan Institute and the Foundation for Educational Choice released a report (which I co-authored with Stuart Buck of the University of Arkansas) that scrutinizes the financial statements of the 59 pension plans covering most teachers in the United States. We applied private-sector-style standards to their estimates of future liabilities, and adjusted their asset values to fully reflect the drop in stock prices the past two years.

The results aren’t pretty. Applying more realistic standards, these plans are $933 billion short of the assets needed to cover their promises to retirees, or more than $18,600 per public school pupil.

That figure represents a debt that governments owe to active and retired teachers — and paying it off will mean a combination of higher taxes and lower education spending in classrooms.

How did this gap grow so large? Public pension plans made risky bets on equity investments and assumed that fast gains in the stock market would enable them to cheaply provide generous pensions.

When the stock market performed strongly (such as during the tech bubble of the late 1990s), this strategy appeared to be working — and then some. Many state legislatures chose to sweeten retiree benefits because their pension plans appeared to be overfunded.

Then, the pendulum swung the other way and the stock market reported negative returns during the past decade. Employees are still owed generous benefits, but pension funds are in much sorrier shape — and they’re telling state and local governments to cough up lots of cash to fix the gap.

It’s obvious why legislators behaved like they did. Increasing pension benefits makes employees happy now and mostly creates problems for future legislatures, years or decades down the line.

Unlike pensions in the private sector, public pensions used expected asset returns to estimate how much cash was needed today to pay future benefits. This was despite the fact that those investments were risky, and the risks could not be passed on to pension beneficiaries, whose benefits are guaranteed regardless of what the market does.

Private sector pensions instead base funding estimates on the risk actually experienced by pension beneficiaries — that is, a low risk similar to that of a corporate bondholder.

State lawmakers and taxpayers are faced with two challenges: what to do about the existing gap and how to prevent future gaps.

On the existing gap, the news is not good. The gap represents promised compensation to employees for work already performed. In general, it can only be closed by cutting checks during the next several decades to pay those benefits.

Several states have begun taking action to prevent future gaps from forming. New York, New Jersey and Illinois have enacted reforms that reduce the generosity of pensions for newly hired employees.

These are steps in the right direction, but they do not go nearly far enough. Because the reforms apply only to new employees, they will take years to produce real savings. Most problematically, these austerity measures are likely to be undone by future legislatures.

There’s only one way for states to break the cycle: move employees from defined-benefit pensions to 401(k)-style defined-contribution plans.

Corporate America has recognized that defined-benefit pensions are unaffordable and unsustainable. For the good of taxpayers across America, it’s time for governments to make the same realization.

Josh Barro is the Walter B. Wriston Fellow at the Manhattan Institute. His new report, “Underfunded Teacher Pension Plans: It’s Worse Than You Think” is available online at www.manhattan-institute.org/html/cr_61.htm.